Internal rate of return (IRR) reflects the compounded return produced by a project. IRR is best used in tandem with other measures, such as Net Present Value (NPV), especially in forestry. Let’s explore why.
Q: Does IRR provide a reasonable estimate for the risk-adjusted discount rate for a given forestry investment?
A: No. IRR challenges those of us estimating risk-adjusted discount rates. IRR does not, per se, provide a “proper” or “appropriate” signal for the risk associated with a given forestry or timber investment. Rather, it specifically and by definition simply provides the rate of return that produces an NPV of zero given the assumed cash flows.
Another way to think about this is that IRR gives us a good signal for the returns associated with our cash flow “story”. Assuming we’ve accounted for concerns with the reinvestment rate (see next question), the IRR gives us a useful measure of investment performance especially when used in conjunction with NPV.
Q: If a forest analyst quotes an IRR, what questions should we ask to better understand the validity of this number?
A: To better understand the context and assumptions about a stated IRR, ask two questions. First, “What is the assumed reinvestment rate?” This question alone indicates whether or not the firm is aware of or considered the reinvestment rate issue. Ideally, the person will respond, “we assumed that interim cash flows were reinvested at the cost of capital” or some other reasonable discount rate. Otherwise, the IRR may overstate, if not directly misstate, the potential returns of the investment.
Second, “When do interim cash flows occur in the life of the investment?” With an improper reinvestment rate assumption, IRR’s overstatement of potential returns will be worse when cash flows occur sooner rather than later. Why? Because the assumed reinvestment rate goes into effect sooner – it’s applied early on generated cash flows – and the returns from this overstated IRR accumulate for more years. This reinforces why the ideal application for IRR is a project with one outgoing initial investment and one incoming cash flow at the end of the investment. In that case, IRR provides a perfect read on annualized returns.
Click here to learn about “Applied Forest Finance” on February 3rd in Atlanta, Georgia. The course details necessary skills and common errors associated with the financial analysis of timberland and other forestry-related investments. All students receive a copy of Forest Finance Simplified.